What (really) moves markets?

Over the long term (beyond a six month time frame), stock market movements are driven by a combination of fundamental factors. Those include liquidity, economic and earnings growth, and shocks.

Over the medium term (a one to six month time frame), sell offs in the stock market are typically brought about by overly optimistic enthusiasm towards risk assets. That excessive optimism can be seen in positioning in portfolios that is overly biased towards risky assets (i.e. higher beta, higher volatility assets, like most equities). A subsequent normalisation then generates a sell off.

Over the short term (up to two weeks) the behaviour of markets is dominated by fear and greed. This is the timeframe over which the Daily RAG provides incisive insights into market direction. Last year our subscribers enjoyed a positive recommendation hit rate of nearly 70%! Newsflow is often used to explain the movement in prices and, at a micro level, that is often the case. Good earnings can push a stock higher. A bid for a company will also similarly move a share price dramatically higher, while a profit warning can achieve the reverse. For the market as a whole, though, the factors that can single handedly move the major equity indices are few and far between: Surprise announcements of central bank stimulus or tightening can change stock market trends; the surprise election of new governments with radical new agendas can fuel a stock market’s rally; while major natural disasters can also impact the near term trend of markets (e.g. Fukushima nuclear disaster, Hurricane Katrina in New Orleans). Above and beyond those factors, though,the short term movements of the stock market are primarily dominated by ‘fear and greed’.

Our RAG models measure fear and greed in global financial markets. We use those models as our primary input into making short term 1 – 2 week recommendations on equity indices. Typically we aim to lean against the prevailing sentiment, once we judge it as having become too strong in one direction or the other. For example, when the market is fearful, it pays to be greedy (long major equity indices). When the market is greedy, it pays to be more cautious and either remove the long positions or go short equity indices.

We complement our risk appetite gauge (‘RAG’) models with further research to reinforce our recommendations. For example, we also use models which measure downside put protection in portfolios, while a variety of volatility models can contain interesting and insightful information, as can certain technical models. We use these and other models to help confirm/challenge our understanding of the short term market environment, as determined initially using our risk appetite models.

What is risk appetite?

Risk appetite measures the amount and type of risk that an organisation, or an individual, is prepared to seek, accept or tolerate. Investors that seek more volatile, higher risk assets for their portfolio are said to have a high ‘appetite for risk’. Investors which look to build portfolios with a high level of defensive assets, like government bonds, cash or low volatility, defensive sectors of the stock market (e.g. consumer staples), are ‘risk averse’.

The same approach can be applied to the market as a whole. The market is, of course, simply a collection of individuals and corporate entities. As such, on trading days when higher risk, higher volatility assets, en masse, outperform lower volatility, lower beta assets then the market is risk seeking/risk loving. On days when the lower volatility assets outperform higher volatility ones, then the market is risk averse. Some days, of course, the market simply drifts with little overall direction (i.e. it's risk neutral).

We measure actual daily ‘risk appetite’ for the market as a whole. This is done by plotting the relative daily performance of higher risk asset prices against lower risk asset prices. By drawing upon a wide range of financial market prices across the global landscape every trading day, we plot ‘risk curves’. Every trading day we plot several of those curves. We then blend, sum and smooth them to create the RAG models. In a globalised economy and globally interconnected financial markets, appetite for risk is a global phenomenon, that washes around the globe as the different parts of the world move into their daytime trading hours.

How to trade with these models?

We designed our risk appetite gauges (‘RAG’ for short) in 2004 and have run them every trading day since that time. They generate 1 – 2 week BUY or SELL signals for equity indices. We primarily use them to trade and make trade recommendations on the S&P500, NASDAQ100, Russell2000, DAX30, STOXX600 and similar equity index futures. We always operate the trades with a recommended stop loss so that we know, ahead of time, how much is at risk.

The measurement of risk appetite (i.e. fear and greed) feeds into our models and creates a 1 – 2 week oscillator type movement, which generates BUY and SELL signals. The chart below is a recent example from 2018, shown with the NASDAQ100.

Our approach is primarily to lean against the extremes of measured ‘greed and fear’. When the market is fearful, it pays to be greedy (i.e. move LONG equity indices). When the market is greedy, it pays to be more cautious and either remove the LONG positions or go SHORT equity indices.

In addition, we combine our risk appetite models with our view of the underlying multi month trend in equities (as determined in our monthly ‘Tactical Equity Asset Allocation’ product) to generate approx. 20 – 30 trade recommendations per annum. These are updated every morning at around 9 – 9:30am London time (and then left on with a stop loss until the following trading morning, when they are re-assessed).

Since we designed these tools in 2004, we have published the Daily RAG to professional investors/traders every business day (except between Christmas and New Year). As such we have experienced all types of markets, and operated through pretty much all environments. The team therefore has considerable experience. Chris Watling, the CEO & Founder of Longview Economics, has been working continually in US and other global equity markets since 1994. Harry Colvin, Director, has operated in US markets since 2006.

Why risk appetite?

In the short term markets rarely respond to newsflow as predicted by economists, market watchers, pundits and others. A key economic data point might be stronger than economists expected – yet equity markets often move lower, reacting in an unexpected way. The same can be said of geopolitical events. Both the election of Trump and the vote for Brexit were key concerns for equity market participants. Yet in both instances after a period of hours, or a few days in the case of BREXIT, the stock market reversed its initial weakness and rallied hard. Even the response of the stock market to major central bank announcements can be unpredictable.

That challenge of forecasting stock market movements in response to newsflow reflects the fact that the key driver of equity markets (at an index level) on a short term 1 – 2 week basis, is ‘greed and fear’. Greed and fear (a.k.a. risk appetite) proxies positioning, and as such gives us key insights into likely future short term market direction.

Over the short term, markets are deeply emotional. Fear and greed dominate the short term price swings. Leaning against those emotions provides an element of alpha that, if traded skilfully, can be extracted from markets.

How do RAG models work?

We designed the risk appetite models in 2004. Initially we modelled and tested RAG1. We then created other models using the same concept (but with different inputs and, in some instances, over different timeframes).

Risk appetite models measure the global financial markets’ appetite for risk. They achieve this by drawing ‘risk curves’. They draw several of these curves each day and aggregate, and smooth over various timeframes, the measured appetite for risk.

The curves tend to act like a metronome. Swinging to one side as markets are greedy, and then swinging back towards the other side, for a period (as fear dominates market behaviour). The extremes in emotion (appetite for risk) then create opportunities. By measuring and quantifying risk appetite, our models flag up when the emotion in the market is 1, 2 or more standard deviations extreme. Depending on the type of market environment at work at that time, we then recommend leaning against that emotion.

We think this natural rhythm reflects human emotion (although we have no proof). After markets have been ‘risk on’ for a period of days, traders typically become less inclined to keep chasing those markets higher as they have then already established their LONG positions (i.e.: the LONG trade becomes somewhat crowded). A pause or some giveback then ensues. After a period of giveback (or a sharp pullback during a bout of volatility), investors, in general, then switch into fearfulness, and our risk appetite models tend to signal a LONG/BUYing opportunity.

“Generally very good timing of buy and sell signals backed up by excellent commentary and reasoning for the signal” ... “has made me wait for the signals rather than ending up overtrading at points where clear signals do not exist” - Ex-London City Stockbroker

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“Their timing tools are amongst some of the best available and help us time entry into and out of key portfolio positions” - Thomas Anderegg, Managing Partner, CEO & CIO, Silversea Asset Management